Last Updated on December 28, 2020 by Oddmund Groette
Investing in dividends has been known to be a tried and tested method for accumulating wealth. Why? Because dividend stocks have historically outperformed non-payers with a wide margin.
But how do you go about constructing a dividend portfolio? What kind of stocks are most likely to continue to pay and grow the dividend? As a dividend investor, you want to grow your dividends with time.
It could pose a challenge to many in finding the right dividend-paying stocks. There are certain factors that should be aligned in order to make a successful investment with higher returns. The question is: what do you look for in dividend stocks? How do you evaluate dividend stocks? Which stocks are likely to continue growing the dividend?
Certain dividend ratios are heavily adapted by the investors to analyze and evaluate dividends that the company may or may not payout in the future. Three simple factors can give you good indications of the safety of the dividend: the leverage, the payout ratio, and the sector. Moreover, it is also advised to look through the track record of dividend payouts of the company before investing in the stock.
The above factors are, of course, very general. At the end of the day, stock picking is difficult, and there is no general formula that works all the time.
Understand dividend investing
Before you start investing in dividend stocks you should make sure you understand all the pros and cons of dividend investing. For example, total returns for dividend stocks assume all dividends are reinvested at the moment of distribution. That is often not the case. Furthermore, when calculating total returns you should keep in mind that taxes on dividends are not included. Thus, if you are in a taxable position, the historical returns from dividend stocks are exaggerated.
We have written extensively about the pros and cons of dividend investing on our landing page for dividend investing. We strongly advise having a look:
What is a dividend?
The one thing that all dividend investors must know is this: A dividend is a cash distribution that comes from the company’s earnings to its shareholders. How the company allocates the capital is up to the management and Board of Directors. For instance, a mature company with potentially low chances of growth may choose to pay dividends to its shareholders, while a younger and growing company might choose to reinvest the earnings into the business. As an investor, you need to evaluate where your money compounds the best: in your pocket or in the company’s pocket?
At the end of the day investing is about finding the companies with the best long-term profitability. This comes from strong cash flow which is discussed later in the article. The reason why cash flow generation is given significance is that it is needed to pay those very dividends.
Leverage, also known as the leverage ratio in financial terms, is a measurement that assesses the amount of capital that comes in the form of debts or the company’s ability to meet all its financial commitments. Evaluating this factor holds great significance because companies typically depend on a mixture of debt and equity in order to finance their functioning. The debt needs to be serviced no matter the profitability.
An excess of debt is never good for the company itself or for its investors. So if the company’s operations are able to generate a higher rate of returns in comparison to the interest rate on its loans then it could become a source of increasing growth. However, on the contrary, not enough debts on a company can also become a subject of raising questions like the company’s reluctance to borrow. This could sign towards the tight operating margins.
Companies with debt often become vulnerable and fragile. If they run into problems or interest rates rise, they might have to allocate capital to service the debt, and not “service” the dividend.
Debt lowers the margin of safety. The best example of this is what happened to banks worldwide during the GFC in 2008/09. Up until then, many banks were included in the revered Dividend Aristocrat list. As we know, it all came tumbling down. Because banks are heavily leveraged and very cyclical, they were hit by two storms at the same time. Since the great recession of 2007 to 2009, the attention on leverage ratio has increased.
Some companies which are non-cyclical and less likely to get disrupted might take on higher levels of debt. As such, there are no hard rules as to what is an excessive debt level. However, to play safely, an investor should always aim for low debt levels. We like to see levels less than 2x EBITDA and max 0.5 to assets.
The payout ratio
Also known as the dividend payout ratio is evaluated as the annual dividends per share (DPS) and dividing it by earnings per share (EPS) (or dividing total dividends by the net income). The dividend payout ratio represents a chunk of the company’s annual income per share that the company is distributing in the form of cash dividends per share.
In general, a company that is paying less than 50% of its earnings as the dividends payout is taken as more stable and represents the potential in increasing its dividend in the long haul. On the contrary, a company with a dividend payout higher than 50% of its earnings holds lower chances of raising their dividends as compared to the companies with a lower dividend payout ratio. We can say a low payout ratio increases the margin of safety (of the dividend).
The amount that is not paid out in the form of dividends to the shareholders is known as the retained earnings meant to be reinvested in the company’s growth and potentially higher returns. While a strong dividend ratio may reflect better on the cash account, paying higher dividends does raise questions over the company’s future plans.
The dividend payout ratio can also be used to analyze the dividend’s sustainability. Generally, companies are not too enthusiastic to cut dividends as that can make the price of the stock drive down and even put the management in a bad light. So let’s say, a company has a payout ratio of over 100%. This means that the company is distributing more money to the shareholders than it is earnings, resulting in possibly lowered dividends and further being forced to stop paying dividends altogether.
Free Cash Flow (FCF)
Free cash flow is a way to calculate the amount of cash that is available for the equity shareholders of the company after paying all the other expenses, debt, and reinvestments.
Why is the cash flow so important? That is because the earnings have items that are not paid in cash, like for example depreciation. The dividend is, of course, paid in cash, and some businesses have a substantial difference between earnings and cash flow, like for example Federal Express (FDX). Thus, a dividend investor needs to check both the free cash flows and the cash equivalents deposits.
Investors typically want to see a company’s dividends payouts completely paid by the cash flows. Analysts generally use this method to see if the stock repurchases and dividend payments are paid with free cash flow to equity or with some other type of financing. If the FCF is lower than dividend payments and the expense of buying back shares, this means that the company is either using debt, the current capital, or issuing new securities for funding. Current or existing capital is referred to as the retained earnings made in the previous periods.
Check out the sectors
In the race to pick out the most profit-making dividends and the companies issuing them, it becomes quite common for investors to leave out the broader aspect of the picture. Evaluating sectors and trends play a crucial part in creating better and integrated projections of future returns. For instance, oil can be growing exponentially but a sudden plunge in the prices can potentially create havoc on the earnings. Such an incident can lead to stock depreciation and a cut back in dividend payouts.
Evaluation based on industry and sector trends helps pick more profitable stocks and invest while keeping in focus the potential growth of the company and skipping over those which are more prone to dividend cuts. For instance, generally speaking, stocks in healthcare and pharmaceuticals are strong enough to cope with minor market plunges. This creates a path for a consistent and stable increase in dividends while moving ahead.
You want to invest in companies that are less influenced by outside random factors such as the oil price. The more the end result is dependent on the management or a mega-trend, the better.
However, it is also important to keep in mind that a sector can always change behavior as time passes. For example, investing in the soft drink industry has historically been a strong bet. But it is also important to acknowledge that as time passes, consumers are becoming more aware of health issues and growing towards living a healthy lifestyle. Thus, investors should consider and recognize such factors before committing themselves and their money.
The robust portfolio
Creating a robust portfolio doesn’t just mean to construct it in regards to higher returns. Obviously, yes total return is kind of the main point, but a portfolio should be designed in a way that minimizes unnecessary risks. A lot of investors make the mistake of running after high yields and forgetting about the risks and what a high dividend payout really represents.
Similarly, building a strong portfolio is about diversifying the risks away. There are certain factors that affect the market environment and unfortunately, the investors have no control over them. But diversification plays a major role in decreasing those risks. Many even pose a very important question over the percent of dividends to hold in their portfolio.
This is a fair enough question, as experts strongly advise to diversify your portfolio based on an individual’s objectives of investing, strongly based on their risk tolerance and time horizon. Every investor has their own goals and how much they are willing to risk in the process. Not everyone has the same tolerance for risks that lie in their comfort zone and knowledge base.
So it’s okay, in fact, it is advised to diversify your portfolio in US stocks, international stocks, bonds, real estate, etc leveraging their percentage based on your customized goals and knowledge base. Moreover, as mentioned above, it is important to diversify by sectors as it is an unnecessary risk to put all your eggs in the same basket. A portfolio with stocks of companies that have similar characteristics, belonging to the same industry can get influenced by the same market fluctuations, which can cause the portfolio to severely underperform.
Put short, a robust portfolio has a margin of safety and should be constructed to make it as less fragile as possible. You never know where the next Black Swan pops up.
On our portfolios page we put together portfolios we believe are reasonably safe, however, they are not suggestions to buy or sell.
Dividends stocks are a great opportunity for investors to grow their returns, hence it explains the need to properly evaluate them. The above-mentioned ratios and checkpoints do give valuable insights into the stocks’ ability to make dividend payouts but it is also important to remember that anyone analyzing dividend stocks should refrain from sticking to only one of these checkpoints. Only your own experience can guide you in the right direction.
Since there is always a possibility for stocks to get affected by other factors that may result in dividend cuts, investors are better advised to use a combination of ratios in order to reach a better evaluation of dividend stocks.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.